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Investments can deliver a major source of income and tax implications for individuals.  Each major type of investment income is subject to special tax treatment.

Understanding how your investments are taxed is an important consideration for investment planning since after-tax yield is more important than gross returns.  The most common types of income most investors will receive are interest, dividends, and capital gains.

Inside a registered account, like an RRSP or TFSA, these earnings are not taxed.  The total withdrawal from an RRSP is subject to income tax, while TFSA withdrawals are not.  For investment income that is subject to tax when it is earned, the effective income tax rate can vary widely for an individual.

What You Need to Know

Interest Income

Interest income refers to the compensation an individual receives from making funds available to another party. Interest income is earned most commonly on fixed income securities, such as bonds and Guaranteed Income Certificates (GIC).  It is taxed at your marginal tax rate without any preferential tax treatment and is taxed annually whether or not it has been withdrawn from the investment.

Example:

An investor buys a 10-year GIC that has agreed to pay him 4% annually.  If the investor bought the GIC for $100, the contract stipulates that they will earn $4 of interest each year for the next 10 years.  The investor must report the $4 of interest income on their income tax return each of those 10 years.

Since interest income is reported as regular income, like employment income, it is the least favourable way to earn investment income if it is subject to income tax.  Typically, GICs offer relatively less risk than other investments to compensate for lower gross and after-tax returns.

Dividend Income

Dividend income is considered property income.  A dividend is generally a distribution of corporate profit that has been divided among the corporation’s shareholders.  The Canadian government gives preferential tax treatment to Canadian Controlled Public Corporations (CCPC) in the form of a dividend income gross up and Dividend Tax Credit (DTC).

Taxpayers who receive eligible dividends are subject to a 38% dividend income gross up, which is then offset by a federal DTC worth 15.02% of the total grossed up amount.

Example:

 A shareholder of a Canadian Controlled Public Corporation is paid a dividend of $100.  This income is an eligible dividend and is subject to the gross up and the DTC.  The dividend would be grossed up 38%, so the income is now considered to be $138.   The DTC would be 15.02% of $138, the grossed-up amount, equaling $20.73.  Therefore, the shareholder would report a dividend income of $138, but would have their federal taxes reduced by $20.73. 

The rationale for the gross up and DTC is related to the fact that dividends are paid in after-tax corporate earnings.  If there were no adjustments to the dividend, it would result in the dollars being double taxed.   This tax treatment makes dividends a more tax efficient way to receive income than interest income. Tax is payable when the dividends are paid out.

Different rules apply for dividends derived from non-Canadian and private corporations and can offer different tax treatment and advantages when professional tax expertise is employed.

Capital Gains

Capital gains are realized on equity investments (such as stocks) that appreciate.  For example, if an investor bought a stock at $6 per share and sold at $10 per share, they would have earned a capital gain of $4.  In Canada, only 50% of a capital gain is subject to income tax.  In this example only $2 of the gain would be taxed.  Another desirable trait of capital gains income is that tax is not due until the investment is sold or deemed to have been sold.  This provides the investor with a measure of control over the timing of taxes.  Whether or not they are the most tax efficient income depends on your province of residence and subsequent tax rates.

The Bottom Line

It is important to ensure that investors understand their tax situation and the implications that different types of investment income can have on future taxes.

Financial, retirement and income planning should include the anticipated tax obligations at both the federal and provincial level.  Ensuring an investor’s expert advisors understand overall objectives, risk tolerance and retirement timing can allow them to maximize after tax returns.

By: Michael Lutes CFP, CLU

Certified Financial Planner

Introduction

In Canada, the taxation of passive income earned by corporations has been a topic of interest and debate for many years.

The rules and regulations surrounding this income have evolved, impacting how businesses manage their investments and financial strategies.

In this blog post, we will delve into the essentials of Canadian corporate passive income, including what it is, how it is taxed, and strategies for optimizing your corporate investments.

What is passive income?

Passive income refers to the income earned by a corporation from investments in assets such as stocks, bonds, rental properties, and other passive sources. This income is distinct from active business income, which is generated from a corporation’s core business operations.

Common types of passive income include:

1. Dividend Income: Earnings received from investments in shares of other corporations.
2. Interest Income: Earnings from investments in bonds, GICs, or loans.
3. Rental Income: Income generated from leasing out real estate properties.
4. Capital Gains: Profits realized from the sale of investments, such as stocks or real estate.

How is passive income taxed?

Taxation of passive income is governed by the Canadian Income Tax Act. The key principle is that passive income is subject to a higher tax rate compared to active business income to discourage corporations from accumulating excessive passive investments.

Moreover, having too much passive income in any given year will reduce or eliminate a corporation’s access to the following year’s Small Business Deduction, the effect of which can be an additional approximately 15% income tax.

Strategies for managing passive income

To minimize passive income and avoid the potential loss of the Small Business Deduction, business owners should consider the following strategies:

1. Withdraw additional funds for investment in RRSP or TFSA accounts.
2. Use accumulated Capital Dividend Account (CRA) credit to withdraw funds tax-free and reduce potential for passive income.
3. Remove funds tax-free by having the corporation repay any outstanding shareholder loans.
4. Focus on capital gains-oriented investment. Unlike interest and dividend income which is earned regularly and taxed in the year it’s received; capital gains can be realized strategically and only 50% of capital gains are included in income.
5. Let your winners ride! In other words, if you have unrealized capital gains, you might consider hanging on to them until a future year when you may avoid a further reduction of your SBD. Or hang on and sell them in a year when you already have greater than $150,000 of passive income and have already eliminated the SBD anyway.
6. Spread out your gains. Instead of deferring capital gains to future years, sell your winners over two or more years to potentially avoid reducing your SBD.
7. Implement an Individual Pension Plan (IPP). An IPP is essentially a business owner’s very own defined benefit pension plan. The money contributed is eliminated from the calculation of passive income.
8. Buy permanent life insurance inside the corporation. The investment income is sheltered inside the policy as “cash value” and doesn’t count to the calculation of passive income. Furthermore, on death the entire death benefit can often be paid out to shareholders tax-free.
9. Donations from a corporation will reduce the funds that would otherwise be producing passive income. Further, if donating securities or funds with unrealized gains, there are additional benefits such as no tax payable and a credit to withdraw funds from corporation tax-free.

Conclusion

Understanding Canadian corporate passive investment income and its taxation is crucial for businessowners looking to optimize their financial planning strategies. By staying informed about the rules and employing effective tax planning strategies, businessowners can strike a balance between accumulating passive investments and managing their tax liabilities. Consulting with a qualified tax professional or financial advisor is often recommended to navigate the complexities of corporate taxation in Canada effectively.